The market's not buying the Fed's 'leap of faith'

Pay no attention to those tumbling energy prices, the Fed seems to be telling the market, all will be back to normal soon.

That was the overriding message that came through from a summary of the December Federal Open Market Committee meeting, where central bank officials approved the first increase of its key funds rate in more than nine years.

In discussions leading up to the decision, Fed officials repeatedly indicated that the energy decline, which has seen U.S. crude prices tumble more than 30 percent over the past year and 63 percent from the late June 2014 highs, ultimately would abate and get inflation back on a normal trajectory.

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Consequently, officials decided that the prospects for inflation normalizing toward a 2 percent growth rate coupled with the labor market tightening was reason for the Fed to get ahead of the curve and start hiking rates.

The trouble is, the market's not buying what the Fed's trying to sell.

Dollars
Jay Directo | AFP | Getty Images

"I can safely say the bond market hasn't been buying it for the last couple of years," said Kathy Jones, chief fixed income strategist at Charles Schwab. "It doesn't look like it's buying the story right now."

Participants currently are pricing in half the four rate hikes FOMC members figure for 2016, despite assurances Wednesday from Fed Vice Chair Stanley Fischer, in a CNBC interview, that the committee remains on course for aggressive monetary actions in the year ahead.

In the bond market, meanwhile, yields have been rising steadily over the past three months, but remain far from projecting substantial inflation pressure ahead.

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"I'm disappointed because I'm not seeing the answers to the questions I have," Jones said. "Why do they think falling inflation is transitory? I'm not sure that question has been answered."

The disparity between the Fed's words and the market's interpretation sets up a challenging environment in 2016, where investors again are left to parse through FOMC language without a clear road map for policy.

Reaction was evident in the Fed futures market, where the possibility for a March rate hike dipped to 51 percent after the FOMC minutes were released at 2 p.m. EST Wednesday. Futures earlier in the day had indicated a 55 percent chance of an increase.

The disparity well could be nestled in the Fed's denial that the decline in oil is more rooted in supply and demand fundamentals plus a stronger dollar. Officials instead believe energy is experiencing factors that are going to "dissipate," a word used five times in the minutes. Oil settled at $33.97 a barrel Wednesday, notching a seven-year low for West Texas Intermediate.

"We've been in a low inflation world for how long now? Many, many years," Jones said. "The assumption that this is transitory is kind of a leap of faith. Even if we get higher wages, it's not clear to me that we get higher inflation."

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"They seem to have this optimism that the models they're using, particularly the labor market models, will result in a tight labor market, that if wages rise, demand will rise enough to push prices higher," she added. "It's what we've all been waiting to see. I can't say there's anything in [the minutes] that makes me any more of a believer today then before I read this."

Some FOMC members were cautious enough about inflation prospects that it made the rate hike verdict "a close call," according to the minutes.

The decision, however, was unanimous, with "uncertainty about inflation dynamics" leading officials to emphasize "the need to monitor the progress of inflation closely."